How Taxes Work: Brackets, Deductions, Allowances

By Jon Scott

  • How to use marginal tax rates to calculate your actual tax percentage

  • Above-the-line and below-the-line deductions

  • Types of important deductions (ie American Opp Tax Credit for college students, Child Tax Credit, and others people may not know about)

  • When to itemize vs taking the standard deduction

  • Allowances and how many you should take based on your filing status

Abstract: A primer on

Have you ever heard someone claim to purposefully make less money in order to pay lower taxes? Truth is, this notion is completely false for federal income taxes. Federal taxes are marginal rate taxes, meaning each dollar of income is taxed at the applicable rate. Let’s break that down further:

As an example, let’s say you made $75,000 this year and you are filing as a single individual:

  • Your first $10,274 will be taxed at 10%

  • Your next $31,500 will be taxed at 12%

  • Your remaining $33,225 will be taxed at 24%

  • Your total federal tax paid (minus and deductions, tax credits, etc.) will be $12,781.

However, CPA and tax websites exist because taxes are complicated. There are many deductions, tax credits, and other factors that affect your federal tax bill.

Tax Credits

Here are some common tax credits, however check the IRS website for a full list of tax credits.

Child Tax Credit

The Child Tax Credit for each qualifying child with a social security number that is valid for employment in the United States. The requirements for the child include:

  • Be under age 18 at the end of the year

  • Be your son, daughter, stepchild, eligible foster child, brother, sister, stepbrother, stepsister, half-brother, half-sister, or a descendant of one of these (for example, a grandchild, niece or nephew)

  • Provide no more than half of their own financial support during the year

  • Have lived with you for more than half the year

  • Be properly claimed as your dependent on your tax return

  • Not file a joint return with their spouse for the tax year or file it only to claim a refund of withheld income tax or estimated tax paid

  • Have been a U.S. citizen, U.S. national or U.S. resident alien

The eligibility requirements include:

  • $150,000 if you are married and filing a joint return, or if you are filing as a qualifying widow or widower;

  • $112,500 if you are filing as a head of household; or

  • $75,000 if you are a single filer or are married and filing a separate return.

However, parents and guardians with higher incomes may be eligible to claim a partial credit.

Child and Dependent Care Credit

This tax credit is meant for an individual or spouse who paid for the care of a child in order for the paying individual(s) to work or actively look for work. Couples who are married filing separately are generally not eligible for this credit. The award is a percentage of the amount of work-related expenses that were paid to a caretaker for the care of a qualifying individual.

The dollar limit for a qualifying individual for 2021 is $8,000 for one individual and $16,000 for two or more qualifying individuals.

Those seeking this credit must identify the name, address, TIN (either social security number or the employer identification number) of the caretaker. For all the requirements, please see the IRS page on the Child and Dependent Care Credit.

Plug-in Electric Drive Vehicle Credit

This credit was enacted by the Inflation Reduction Act of 2022 and is eligible for this list of Model Year 2022 and early Model Year 2023 electric vehicles purchased or delivered on or after August 16th, 2022. See the IRS webpage on the Plug-in Electric Drive Vehicle Credit for more information

American Opportunity Credit and Lifetime Learning Credit

The tax credit helps those with the cost of higher education by reducing the amount of federal taxes owed.

You must meet all the following qualification for eligibility:

  1. You, your dependent or a third party pays qualified education expenses for higher education.

  2. An eligible student must be enrolled at an eligible educational institution.

  3. The eligible student is yourself, your spouse or a dependent you list on your tax return.

You are ineligible if:

  • You are claimed as a dependent on someone else’s tax return.

  • You are married filing separately.

  • You already claimed or deducted another higher education benefit using the same expenses.

  • You (or your spouse) were a non-resident alien for any part of the year and did not choose to be treat as a resident alien on your taxes.

Deductions

Deductions reduce the amount of income before calculating the tax you owe.

Above-The-Line Deductions

Above-the-line deductions are expenses that can be deducted directly from your gross income. Above-the-line deductions are deducted before adjusted gross income. The formula is: Your gross income – above-the-deductions = your adjusted gross income (AGI). The benefit is that these deductions reduce your income tax due.

Below-The-Line (Itemized) Deductions

Below-the-line deductions are taken out after adjusted gross income. Examples include:

  • Mortgage interest of $750,000 or less

  • $250 for educators buying classroom supplies

  • Gambling losses

  • Investment interest expenses

  • $2500 in student loan interest (there are some restrictions)

  • Medical and dental expenses (over 7.5% of AGI)

  • Charitable contributions

  • Moving expenses

  • Sales tax

  • Personal property tax

  • Miscellaneous expenses

  • See more comprehensive list here

Itemized Deductions vs Standard Deduction

Whether to choose the itemized versus the standard deduction will depend on your filing status, and how much in itemized deductions you are eligible for.

Standard Deduction Amounts

If your total itemized deductions do not exceed the standardized deduction amount based on your filing status, you will want to opt for the standardized deduction.

Homeowner Deductions Credits

There are multiple tax credits for homeowners, however, here are some items you can deduct:

  • State and Local Real Estate Taxes that qualifies as home mortgage interest and mortgage insurance premiums

  • State and local general sales taxes (instead of state and local income taxes as an itemized deduction)

Here are some items you many not deduct (not a complete list):

  • Insurance (other than mortgage insurance premiums)

  • Wages paid for domestic help

  • Depreciation

  • Cost of utilities

  • Internet or wifi

  • Homeowners association fees, condominium association fees

  • Repairs to home

For a complete description of homeowners deductions, see the IRS Publication 530.

Investment Related Deductions

Work Related Deductions

Work related deductions include the following:

How you should file your taxes

You are able to file your taxes for free through the IRS Free File Options located on the IRS website if your AGI is less than $73,000. The IRS site links to a list of providers who will file your federal tax return without fees. It is important to note that the free file option only covers federal tax returns, so these providers often charge for state tax preparation.

Generally, you can file taxes on your own if you are filing as a single individual. However, there are some situations where you should hire a CPA to do your taxes. These situations include, when the IRA contacts you, you have a small business or side hustle providing a significant amount of income, you’re planning for your kid(s) to go to college, you own a rental property, you are self-directing your retirement. CPAs do cost money, but they can end up saving you a lot more money than if you complete your taxes on your own.